Know Your History

Doug White is no investing novice. An entrepreneur whose 17-year-old company sells and services Apple computers small and mid-sized businesses, White understands that markets don’t always go up. But when they dive, it still hurts. “I’ve lost more money in my pension this year than I’ve put in to save on taxes,” says the 53-year-old Pennsylvanian about his Simplified Employee Pension Individual Retirement Account. Even so, White resisted the urge to dump stocks. He and wife, Celeste, 52, believe the only way to a comfortable retirement is to cast their lot with the market. “We don’t come from affluent families; we don’t have anything to rely on other than our own planning,” says White, calculating that he may need to postpone retirement by five years to make up lost ground. “We have no choice but to stay the course.”

White is taking a page from history. His continued faith in stocks is supported by decades of market data. History shows that stocks generate better returns than all other investments. One dollar invested in stocks in 1926 would have been worth $3,246 by the end of 2007. By comparison, the same amount in treasury bills would add up to $20.19.

The only reason to sell now is if you believe the stock market will continue to decline—by a lot. But, consider this: since 1929, the average bear market decline in the S&P is 38%. This bear, however, has handed investors a 43% drop from Oct. 9, 2007 through the end of October 2008, according to Standard & Poor’s Equity Research. Although further dips could occur, the probability of the market falling much more is growing unlikely. While it’s true that the crash of 1929 ended with an 86% decline, there are a number of important factors at play now that weren’t present prior to the Great Depression. “Back then you had a government trying to raise taxes, tighten credit, not bail out any companies, which is the opposite of what’s happening now,” says Sam Stovall, chief investment strategist with Standard & Poor’s Equity Research. Still, the S&P’s drop in 2008 has evaporated roughly $2 trillion in retirement savings, and that’s enough to make even the most rational investor frightened.
But giving into fear won’t lead to long-term wealth. If anything, it’s a detour to a financial dead end. Selling now only locks in losses and closes off any possibility of recouping. Besides, bear markets always give way to good times. In the 12 months following the last 10 market bottoms (1949 to 2002), stock returns have averaged 32%.

Missing out
Investors might be inclined to pull out now and dive back into stocks once there are signs of recovery. If only it were that simple. The problem is rebounds are usually fast and unexpected, making it difficult for investors who’ve retreated to know when to get back in. That’s because the stock market is a forward-looking mechanism, anticipating the business the business environment about six to nine months ahead. So, stocks historically start improving before the economy does. Markets usually bottom about halfway through a recession, says Stovall. And the upside is easy to miss. Nearly 75% of the gain following a market bottom occurs within the first six months, according to Ned Davis Research. Even then, investors still might not see signs of an improving economy.

It takes surprisingly little to miss out on the best stock returns. Just missing out on the market’s 10 best days during a recovery can have a big impact on overall returns. For the 10-year period between 1998 and 2007, stocks gained a cumulative 77.6%. But if an investor missed the 10 best trading days during that time, the return was just 11.8%, according to Vanguard. “Just as there is risk being in the market, there is risk being out of the market,” says Alfred Osbourne, a senior financial planner with Ameriprise Financial in East Meadow, New York.
Sadly, investors don’t always act rationally. Emotion— not reason—often dictates how we respond to market gyrations. Investors tend to overreact when stocks decline and become overly fearful when they fall. “In up markets there is a bias,” explains Michael Pompian, a director of the private wealth practice with Hammond Associates in St. Louis and author of a book on behavioral finance. “People don’t look at history. They only look at the most recent results, and all of a sudden they find they’ve bought at or near the peak.” Indeed, skittish investors have demonstrated poor timing. In the early months of 2000, just as the Internet bubble was taking its last gasps, investors poured record amounts of new money into equity mutual funds, much of it going to technology offerings. By early 2002, after two years of declines, these investors had had enough and were withdrawing their funds in record numbers—just as stocks were beginning to recover. From its bottom in 2002, the S&P went on to return 22% in the following 12 months. In a well-known study, Dalbar, a financial research services firm, found that while U.S. equity funds had a long-term annualized return of 11.9% for the 20-year period ended Dec. 31, 2004, individual mutual fund shareholders squeezed out only a 3.7% gain, primarily the result of entering and exiting stock funds at the wrong time.

Moving forward
So if selling isn’t the right thing to do, what is? How can investors make their portfolios smarter and better poised to withstand periodic shocks? The key is allocating assets in terms of risk tolerance and investment horizon. “This may be a wake-up call for people who realized they were too heavy in equities,” says Christine Fahlund, senior financial planner at T. Rowe Price in Baltimore. An overwhelmingly stock-heavy portfolio is perfectly sensible for a young investor who’s nowhere near retirement. Someone with a need for retirement income, say, in the next five years, should maintain a mixed portfolio of stocks, bonds, and cash to ride out declines.

T. Rowe Price found that a balanced portfolio of 60% stocks, 30% bonds, and 10% cash declined significantly less during the market correction of 2000 to 2002 and performed only a little worse during the ensuing rebound through 2007 than an all-stock portfolio. You don’t give up much on the upside to protect yourself significantly on the downside. Over the full market cycle from 2000 to 2007, $10,000 invested in a stock, bond, and cash portfolio grew to $48,107, T. Rowe estimates. Over the same period, an all-stock portfolio grew to just $28,316.
Having a balanced portfolio is one part of managing your risk. Rebalancing at regular intervals will help keep a portfolio from getting too out of whack by selling winners and buying laggards. A good place to look would be NDR, whose historic data suggests healthcare and consumer staples—food, beverages, and household products—are likely to be the best performing sectors in the coming year. The firm found this to be true, on average six and twelve months after the start of the last five recessions dating back to 1973. Don’t be afraid to rebalance. After all, it follows the market’s most time-tested piece of advice: Buy low and sell high.

This article originally appeared in the January 2009 issue of Black Enterprise magazine.